After Bulls Flee, Stocks Often Rise

8/29/2011


One of the best ways to make money in the stock market — or any facet of business — is to go against the direction of the crowd and be right. That sounds easy enough, though as anyone who has stared into the depths of a market precipice can attest, it takes some fortitude to whip out your wallet as everyone else runs for their lives.

While it's tough to swim against the tide, our research suggests the rewards can be well worth the effort. Conventional wisdom has long held that it makes sense to buy when most investors want to sell and sell when most investors buy. But conventions don't always reflect reality, so we decided to test the maxim.

For our study, we considered two measures of sentiment:

Investors Intelligence tracks the stance of investment newsletters.

• The American Association of Individual Investors (AAII) Sentiment Survey measures the percentage of individual investors bullish or bearish on the market over the next six months.

AAII data tends to be more volatile than that collected by Investors Intelligence, with more extremely high and extremely low readings. Both the AAII and Investors Intelligence collect their data weekly. While the surveys reflect different populations, both support the conventional wisdom — when everyone is buying, shrewd investors should pull in their horns. And when bulls are scarce, it's often time to charge ahead.

Based on weekly observations since 1989, the S&P 500 Index averaged a 12-month price gain of 11.9% after weeks when AAII bullish sentiment was 30% or lower, well above the average gain of 7.9% for all 1,097 periods. When Investors Intelligence bullishness was 30% or lower, the index's gain averaged 19.7%. In contrast, the index averaged slight declines in 12-month periods after bullishness topped 60%. Quite simply, the higher the percentage of bullishness in either measure, the lower the average return afterward.

Of course, sentiment is not a foolproof indicator. The percentage of bulls was low for much of early 2008, yet year-ahead returns still stunk. Extremely long or very sharp market moves frequently derail trends. If everybody flees to the left, sometimes opportunities await on the right, but you may also run right into the fire that scared everyone else away.

As of Aug. 24, AAII reported 33.4% bulls, while Investors Intelligence bullishness was 40.9%. Both numbers are below the long-run averages, but higher than investors might expect given the S&P 500 Index's 14% decline from July highs. Investors Intelligence reports bullishness remains higher than that seen in mid-June after the index had fallen just 8% from May highs. The data suggest that many investors see the recent declines not as a reason to panic, but as an opportunity to pick up bargains.

Will the current bear market be prolonged or particularly nasty? We don't know for sure, but we intend to follow our typical bear-market playbook: (1) hold extra cash as a partial hedge; (2) watch the Dow Industrials and Dow Transports, paying attention to their ability to avoid breakdowns to new lows; (3) seek opportunities in high-quality, attractively valued stocks; and (4) monitor sentiment and valuation numbers, asking whether investors are so depressed or stocks so cheap that a market bounce is likely. 

 


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